Key Takeaways —
2015 was a poor year for financial markets across the globe and across asset classes (stocks, bonds, commodities, etc.). Among the major global stock markets, the United States was the best performer, but that’s faint praise. What’s more, it was a market in which a handful of large tech/Internet companies (e.g., Facebook, Amazon.com, Netflix, and Google) generated huge gains and helped propel the index into positive territory, while the equal-weighted S&P 500 index actually fell 2.2% for the year.
One striking feature of last year’s investment environment was the difference in the direction of the U.S. economy and U.S. monetary policy versus other major global economies. In December, the U.S. Federal Reserve was sufficiently comfortable with the outlook for economic growth and the potential for inflation to eventually normalize that it made its first increase in rates in nearly a decade.
Outside the United States, regaining more normal economic growth and inflation has remained more challenging. Sharply lower commodity prices (most notably oil), tensions in the Middle East, and China’s slowing economic growth all weighed on foreign stock market returns. Developed international stocks ended the year down 0.4% while emerging markets fared worse, falling 15.8%.
As in 2014, the strength of the dollar exacerbated foreign markets’ underperformance for dollar-based investors, detracting 9% from emerging-markets stocks and 6% from developed international stocks compared to their local-currency returns. Currency effects will always be a shorter-term wild card when investing in non-U.S. assets, but on a fundamental, longer-term basis we believe currency movements may be a tailwind to dollar-based returns going forward after having been a drag on returns the past few years.
The worst-performing areas of the markets were commodity-related asset classes. Commodity indexes were crushed, down on the order of 25%–30% as oil prices hit an 11-year low in December and fell 30% for the year, after plunging 50% in 2014. Energy MLPs, an increasingly popular vehicle for yield seekers (and yield chasers), dropped 35%–40%, wiping out the previous four years’ worth of gains.
Fixed-income offered little respite, with the core bond index gaining just 0.3%. High-yield bonds fared worse, down close to 5%, while floating-rate loans lost 0.7%. Investment-grade municipal bonds were a relative bright spot, with the national muni bond index up nearly 3% on the year.
Investment Commentary – 2016 Outlook
Normally in this commentary we would start off with a recap of the most recent quarter’s performance, and we will do that later in this newsletter. But, given the fact that the world markets are down 8-10% in the first 10 trading days of 2016, we thought it was appropriate to address 2016 first, and then we will step back and look at the big picture in 2015.
The markets around the world are certainly signaling that we have potential for a worldwide recession or at least a significant down turn in economic growth. As you have probably read in the headlines, this is driven by slowing economic growth in China, the dip in overall commodity prices, and most importantly a dramatic fall in the price of oil.
Over the last 15 years, China’s economy has grown at an average of almost 10% annually. This growth was largely driven by infrastructure growth, including projects for new roads, airports, factories, building entire cities, etc. During this period of time of infrastructure growth, it created great strain on the world’s commodity complex, ultimately creating a commodity supercycle (i.e. a very long period, or wave, in the growth of a financial market). Because China was creating such demand for things such as oil, iron ore, copper, and basic building materials, all those prices rose significantly. In America, we saw it most commonly reflected in the price of oil, gasoline and the cost of construction.
China is now transitioning from infrastructure growth economy to a more consumer-based economy. This is a normal progression in the economic development of emerging nations. Most economists believe that long term that is going to be positive, both for China and the world economy, but short term there will certainly be bumps in the road. Whether that includes outright recession in China or just slower growth, we won’t know until the months and or years ahead.
The markets are currently reacting to the fear that lack of growth in China will cause a contagion that could create a worldwide recession. We realize this is possibility, but think it is a low probability in 2016.
Investment Commentary – 2015 Recap
Overall, 2015 was a challenging year for the financial markets in general, and for our portfolios as well. Given our commentary on the 1st weeks of 2016 we thought it would be instructive to break the portfolio down into four categories of investments that highlight their different roles: longer-term return generators; shorter-term risk reducers; hybrid investments, which have elements of both return generators and risk reducers; and alternative strategies. Understanding how we employ the various types of investments we own in our client portfolios should help in setting reasonable expectations of how they will perform.
Longer-Term Return Generators
These are investments or asset classes that we own because of their ability to generate longer-term growth of capital, well in excess of inflation. U.S., developed international, and emerging-markets stocks are the primary long-term return generators for our portfolios. However, we expect them to have higher shorter-term volatility and significant downside risk.
With prospective returns in the low double digits in our base case five-year scenario for European stocks, and comparable or higher return estimates for emerging-markets stocks, we believe we are being well compensated for their risk and that exposure to these markets will pay off over time. For this reason, we have modestly increased our allocations to both in the last 18 months.
Our investment thesis for European and emerging-markets stocks has not changed materially since we added to the positions . In a nutshell, our analysis suggests both markets are undervalued relative to their normalized earnings potential looking out five or so years. Therefore, we expect to benefit from both stronger-than-expected earnings growth and some valuation (price-to-earnings, or P/E) expansion, generating the double-digit type of expected returns noted above. We are confident that long-term we will get paid (with outsized returns) for our current allocations to European and emerging-markets stocks.
Conversely, when it comes to U.S. stocks, our tactical outlook over the coming five years is less positive compared to emerging-markets stocks and European stocks. Unlike in those markets, our analysis suggests U.S. valuations are high. And with U.S. corporate profit margins also above normal, we see potential for disappointing earnings growth (as we saw in 2015) and valuation multiple contraction. Our base case scenario results in middle single digit expected returns for the S&P 500. While that return may exceed that of low-risk core bonds, it is well below the upper-single-digit-type returns we are looking for, at a minimum, from our long-term return generators. Therefore, we are tactically under-allocated to U.S. stocks in our portfolios.
Shorter-Term Risk Reducers
To mitigate the shorter-term uncertainty, volatility, and downside risk that comes from owning stocks, our balanced and more conservative portfolios also have dedicated exposure to core investment-grade bonds. If there is a recession or economic shock that leads to increased risk aversion among investors, core bonds have historically performed well in absolute terms (generating solid gains) and very well relative to riskier assets like stocks that may be down 20%–30% or more. We’d expect a similar performance pattern this time around if and when stocks fall into a bear market. So core bonds have a very important risk-management role, particularly in our more conservative portfolios, where our 12-month downside risk thresholds are lower.
However, given the very low current yield and our expectation for returns in the 0% to 2% range over the next five years, the degree to which core bonds can limit the downside during the current market cycle has been significantly reduced. This past year was a good example of this, with core bonds barely positive while global stocks were negative. That is a high price to pay (in terms of low longer-term returns) for the risk-reduction benefits of core bonds.
So we are in a situation where our two primary asset classes, U.S. stocks and U.S. core bonds, look unattractive relative to their respective return-generation and risk-reduction roles in our portfolios. This has been the case for the past several years and led us to research and invest in other asset classes and strategies that we think are more compelling on a risk/return basis.
Hybrid Investments: Part Risk Reduction, Part Return Generation
As the primary examples of what we consider hybrid investments, we have allocated a portion of our portfolios to a diversified group of fixed-income funds representing a variety of investment categories: multi-sector, global bond and unconstrained. We believe these investments have the potential to generate returns over the next five years that are several percentage points above the core bond index and in line with or better than our base case return expectations for U.S. stocks. Importantly, these funds should have much less volatility and downside risk than stocks. However, in most scenarios, these funds will have higher volatility and short-term downside risk than core bonds, due to their below-investment-grade and/or non-dollar currency exposure.
The final piece of our portfolio is allocated to alternative strategies. These investments also play a dual role of return generator and portfolio risk diversifier. Within our alternative strategies allocation we own multiple strategies: arbitrage/event-driven strategies, trend based strategies and managed futures strategies, to name a few. Broadly speaking, we believe these investments will both add valuable diversification benefits and will also be additive to our balanced and more conservative portfolio returns over the next five years.
Our risk and return expectations for the alternative strategies are roughly similar to our expectations for the hybrid funds discussed above: better returns than core bonds over the long term but with somewhat higher risk, and potentially comparable returns to U.S. stocks over our five-year tactical horizon but with much less risk.
The last 18 months the markets have been driven largely by momentum (a momentum-driven market loosely means that things that have gone up continue to go up and things that have gone down continue to go down, as opposed to a more normal “give and take” among different types of investments). In addition, this market has a lot of similarities to the late 1990’s (e.g. a strong dollar, weak currency in emerging markets, low oil prices, etc.) We were successfully able to navigate those markets, and we believe we will today also.
We were disappointed in our portfolios’ overall performance in 2015. However, we’d reiterate that it is in the nature of our long-term, fundamental, valuation-driven investment approach to go through periods of sub-par performance. It is exactly during these challenging periods that it is most critical, but also most difficult, for an investor to stick with their approach and remain disciplined in order to ultimately harvest the long-term rewards.
We believe our portfolios are well positioned to generate solid returns over our five-year horizon, but we think it is prudent to be prepared for potentially increased market volatility and downside risk (as well as positive returns) over the shorter-term. We may even get the opportunity to add to our undervalued positions or establish some others before this market cycle turns. In other words, we believe the key to successful investing ahead is to maintain the healthy patience, perspective, and discipline necessary for long-term investment and financial success.
Jon Houk, CFP®